Tax alert 03 March 2020

Use of bond benchmarking to justify intra-group interest rate regarding arm’s length principle

In an opinion handed down on 10 July 2019, the Conseil d’Etat helpfully clarified that interest rates used on intra-group loans may be justified through the of bond benchmarking, where no evidence of loans granted by financial institutions was available.

  • Background:

If a taxpayer wishes to apply a higher interest rate than the reference rate set out in Article 39-1-3° of the French General Tax Code, it must, pursuant to Article 212-I of the French General Tax Code, demonstrate that the interest rate that it applies is equivalent to the rate that could have been obtained from independent financial institutions or bodies, failing which the deduction of the interest payments in excess of the amount that would have been charged at the statutory rate is subject to challenge.

Previous cases heard by the Conseil d’Etat[1] had traditionally found that a taxpayer who produced specific evidence satisfied the obligation to justify that such expense was deductible. However, the authorities, relying on a very restrictively drafted[2] administrative doctrine, and encouraged by decisions recently handed down by the Paris’ court of appeal, rejected the use of bond benchmarking in a number of cases[3] as a method of justifying the interest rates used on intra-group loans.

It was against this background that the opinion of the Conseil d’Etat was issued.

In a recent case in which a taxpayer, in seeking to justify that the interest rate applied by a connected company was arm’s length, had produced a study based partly on bond issues carried out over the same period by issuers with a comparable credit rating, the Court decided to stay the proceedings and referred the matter to the Conseil d’Etat for its opinion.

  • The opinion of the Conseil d’Etat:

The Conseil d’Etat provided an interesting clarification of this issue.

The Supreme administrative Court first reiterated that, although the burden of proving that the interest rate is arm’s length rests with the taxpayer, the taxpayer “may provide this evidence using any means”.

In demonstrating that an interest rate is arm’s length, the Conseil d’Etat stated that it was possible “to take account of bonds issued by companies in comparable economic conditions, where those bonds constitute, in the circumstances in question, a realistic alternative to a loan”.

Although this opinion states that a loan taken out with a financial institution or organisation and a bond issue are different in nature, the effect of the opinion is that analysis based on bonds cannot, as a matter of principle, be rejected when used to justify the interest rate on an intra-group loan where the use of such analysis for comparative purposes is justified.

This opinion does not provide a more detailed definition of the term “realistic alternative”, but it may be assumed that companies will have to be able to demonstrate that, if they had obtained financing through a bond issue, they would have obtained comparable interest rates. To that end, they may use information on bonds issued by companies in comparable economic conditions (particularly in terms of credit risk).

Nevertheless, the interpretation of this opinion by the tax authorities and the position of the judges on the concept of “realistic alternative”, which will undoubtedly be further discussed, will need to be closely monitored.

The Transfer Pricing department

[1] CE, 20 June 2003, no. 232832, LeBreton

[2] BOI-IS-BASE-35-20-10-20140415, no. 100 and no. 110

[3] CAA Paris, 31 December 2018, No. 17PA03018, WB Ambassador